Page 25 - FIPI - Policy Economic Report - May 2025

May 2025 POLICY AND ECONOMIC REPORT
OIL & GAS MARKET

Lessons from Economics

Supply shock

Supply shocks occur when there is a sudden change in the supply of a good or commodity that suddenly
affects the price of that good or commodity. Depending on how the supply is affected, supply shocks can
be positive or negative. Supply shocks occur for a variety of reasons, such as natural disasters, monetary
policy, or war.

Positive and Negative Supply Shocks

One positive supply shock that can have negative consequences for production is monetary inflation. A
large increase in the supply of money creates immediate, real benefits for the individuals or institutions
who receive the additional liquidity first as prices have not had time to adjust in the short run.

Their benefit, however, comes at the expense of all other members of the economy, whose money loses
purchasing power as fewer goods are available to them. Real demand drops, causing
economic stagnation.

Negative supply shocks have many potential causes. Any increase in input cost expenses can cause the
aggregate supply curve to shift to the left, which tends to raise prices and reduce output. A natural
disaster, such as a hurricane or earthquake, can temporarily create negative supply shocks.

Further, increases in taxes or labor wages can force output to slow as well since profit margins decline
and less efficient producers are forced out of business. War can also cause supply shocks. The supply of
most consumer goods dropped dramatically during World War II as many resources were tied up in the
war effort and many more factories, supply sites, and transportation routes were destroyed

Supply Shocks Causes Inflation: -

Generally, inflation occurs when all prices go up, whereas supply shocks generally impact one or a few
products, so would not generally cause inflation. However, there are special cases when supply shocks
could cause inflation, such as the supply-chain issue after the Covid pandemic, which disrupted supply
globally across many products and led to inflation.

Real example of oil shock- The most famous supply shock occurred in the oil markets during the 1970s
when the country experienced a period of strong stagflation. The Organization of Arab Petroleum
Exporting Countries (OAPEC) placed an oil embargo on several Western nations, including the United
States. The nominal supply of oil did not actually change; production processes were unaffected, but the
effective supply of oil in the U.S. dropped significantly and prices rose.

In response to the price increase, the government placed price controls on oil and gas products. This
effort backfired, making it unprofitable for the remaining suppliers to produce oil. The Federal Reserve
attempted to stimulate the economy through monetary easing, but real production could not increase
while government constraints remained in place. Here, several negative supply shocks occurred in a
short period of time.

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